Just like a person working for some one expects remuneration or a landlord expects rent from tenant, the provider of funds also expects return. Two types of funds providers exist. One who takes the risk and provides funds for sharing profit or loss. The average expectancy of profit or loss is relatively high in this case. The other one who does not take risk of sharing loss and expects a fixed return over the usage of his money for a certain time period and after its usage gets back the whole sum in a similar way the landlord gets back building or piece of land after the expiry of lease agreement. This expected return on the part of funds providers is called interest rate.
The interest rate is often determined before the debt covenant takes place and usually quoted on the debt instrument. Interest rates are higher over the funds meant for longer period of time as compared to those for the short span of time. Moreover interest rates play significant role in the monetary policy of country therefore determined by the central banks. Though look quite simple but interest rates outline many different forms according to time, functions, and nature of loan agreements. Each of such type has its own implications and complexities.
• Fixed Interest Rate
• Fluctuating Interest Rate
• Nominal Interest Rate
• Real Interest Rate
• Period Interest Rate
• Coupon Interest Rate
• Effective Interest Rate
• Flat Interest Rate
Simple Interest Rate
The basic kind of interest rate used in simple loan and debt covenants between individuals and institutions. To ascertain the amount of interest the rate is multiplied by the principle and period to time often twelve months.
Amount of Interest = Principle x Rate of Interest
Compound Interest Rate
A very important form of Interest often described a most powerful tool in finance. A compound interest rate looks like a simple rate agreed among the parties concern but in reality makes far most difference to the earnings of the lender than the simple interest rate. The difference actually occurs in the calculations where periodical interest earnings are added to the principal for future period computations of interest. In compound interest instead of application of linear rate over a period of time. The formula to be used is: agreement
I = P x (1 + r/n)n
I = Interest, P = Principle, r = Interest Rate, n = number of compounding period
Fixed interest rate
The rates of interest which remain fix during the period of loan accord. This allows the borrower to accurately predict their future payments and lender to accurately predict the future stream of return. It shows the financiers’ expectations for returns over the period of loan based on average return for the period.
Nominal interest rate
A nominal interest is the interest rate before the adjustment of inflation. Normally the interest rates agreed upon are nominal in nature and include the general rate of inflation prevailing in the country. In a condition of higher inflation rates the lower nominal rates are deceiving for the lenders. They need to know the rates of general price hike to undoubtedly ascertain the real returns.
Rn = ((1+r)(1+i)) – 1
Rn = Nominal Rate of Interest, r = Real Rate of Return, i = Rate of Inflation
Real interest rate
Contrary to nominal interest rate the real interest rate is the inflation adjusted rate of interest. This is the real return to the lender. If nominal rate of interest is 10% and inflation rate prevailing is 6% the real rate of interest for the lender is 4% which is the difference of nominal rate and inflation rate and represents a common approximation of real rate of return.
The relationship between real and nominal interest rates can be described in the equation:
(1 + r)(1 + i) = (1 + R)
r = real interest rate, i = inflation rate, and R = nominal interest rate.
Period interest rate
Period interest rate is simply the division of nominal or stated rate of interest over a specific period such for one quarter, one month, or one week. For example if the annual interest rate is 24% than one month interest rate would be 2%. Period interest rates are important to know when dealing with covenants of certain shorter time span. Though effective interest rate is more useful in such situations but periodic rates of return also provide good approximation for general overview.
Coupon interest rate
It is the rate of interest incorporated at the debt instrument and shows a fixed percentage of the face value of the bond over the life of the bond. The separate discussion of the coupon rate of interest is necessary because not all bonds or debt instruments bear the rate on their face. This implies ownership of the bonds and owner’s right to get return. It is the interest rate the bond issuer will pay to the bondholder. For example if you hold bond having face value of $ 15000 as a 10% coupon rate loan stock, you will receive $1500 in interest each year.
Effective interest rate
Effective interest rate is another very important form of interest rate useful in knowing the actual returns. One can say this is a hidden interest rate and can not be seen by common man. But in reality it has significant impact over the financial decisions. The need of calculating effective interest rate arises in compounding where it occurs after a shorter period of time usually semi annually, quarterly, monthly, or even daily. Effective interest rate can not be specified with knowing the compounding frequency and the rate. The formula to be used is:
IE = (1+r/n)n – 1
Where,
IE = Effective Rate of Interest, r = Stated rate or coupon rate, n = Frequency of Compounding.
Example
Interest Rate = 12% per annum and compounding frequency is every month.
Effective Rate of Interest = IE = (1+0.12 / 12)12 – 1 = 12.68%
The greater the frequency of compounding the higher the effective rates of interest and higher the return to the lender.
Flat Interest Rate
Flat rate means the rate of interest applied over the principle regardless of the gradual payments over the period of time. In under developed countries where large portion of economies are normally undocumented the moneylenders usually lend at flat rates. They are also used by many microfinance institutions. They are easy to use and extremely popular. For example, a loan of $2400 can be structured with 12 monthly repayments of $200, plus interest, due of 1% ($24) a month, resulting in a total monthly payment of $224. If the loan contract is for $500000 over 4 months. Interest is set at $20000 (4%) while principal is due in a single payment at the end.